Short Sales Lead to Unexpected Tax Hardships

The tax benefit of short sales may have hit a major speed bump. Short sales allow owners to sell their homes for less than what's owed on their mortgages—with lender approval, of course. The Mortgage Forgiveness Debt Relief Act of 2007 added a key benefit: The forgiven debt amount would not be considered taxable income.

Without that proviso, a seller would have been taxed on a write-off of, say, $200,000 in mortgage debt just as if it had been earned income. And these are typically people who are already in a financial hole.

The law first expired on Dec. 31, 2012, but was then extended through the end of 2013 by the fiscal cliff bill. The Senate Finance Committee is expected to consider an extender bill this spring, according to a law alert at Continuing Education of the Bar (CEB), an affiliate of the University of California and partner of the California State Bar.

Some states have or are considering local relief. For example, In 2011, California approved a provision (Section 580e) under its Code of Civil Procedure that generally bans a lender from claiming a deficiency or getting a deficiency judgment against a seller after agreeing to a short sale.

In August 2013, state Senator Barbara Boxer asked the IRS if California homeowners would be liable for taxes on the forgiven debt in the wake of the federal law's expiration. That would make it recourse debt. Without that clarification, Boxer warned that "distressed borrowers may face the unfortunate incentive to go to foreclosure rather than seek a short sale in order to avoid a large tax bill," according to a statement on her website.

As reported in the Wall Street Journal, the IRS replied that the forgiven debt is nonrecourse debt under the state's law and that a seller would not face federal income tax obligations. (California's Franchise Tax Board also indicated that forgiven debt would not incur state income tax.)

But the IRS notes that there are exceptions, though it didn't describe them in the letter: "Section 580e has certain exceptions to its anti-deficiency provisions. Also, federal law may override California's anti-deficiency provisions in certain circumstances. If any state or federal law would have the effect of nullifying an obligation's nonrecourse status, we would generally consider the obligation a recourse obligation subject to the application of the cancellation of indebtedness provisions of section 61(a)(12) of the Code."

The agency also noted that its opinion applies only to California, despite other states' anti-deficiency laws.

In the current political climate, it's uncertain if an extension of the federal law will happen, says tax attorney Marvin Kirsner at Greenberg Traurig in Boca Raton, Florida. But Congress has always come through in the past with an extension, so there's reason to hope it will again, he says in an email.

At RealtyTrac in Irvine, California, Vice President Daren Blomquist says short sales have dropped from 7 percent of total sales in the first quarter of last year to 5.6 percent this year, and that's at least partly due to the federal law's expiration.

"Homeowners have less motivation to do a short sale because they don't get that tax relief," he says. But, because home prices are rising, owners may not have to do a short sale either.

An extension of the federal law is a big question mark, Blomquist says. "I don't hear a lot of people talking about it, which is a sign that there doesn't seem to be a strong champion for it," he adds.